Information about Asia and the Pacific Asia y el Pacífico

Chapter 6. The Future of Asia’s Financial Sector

Ratna Sahay, Cheng Lim, Chikahisa Sumi, James Walsh, and Jerald Schiff
Published Date:
August 2015
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Rina Bhattacharya, Fei Han and James P. Walsh 

Main Points of this Chapter

  • As incomes in Asia continue to rise rapidly, they are likely to be accompanied by a further rapid deepening of the region’s financial sectors.

  • Demographics could have a large impact on this process as countries with rapidly rising dependency ratios see declining savings rates, and those with falling dependency ratios see increased savings.

  • Asian financial systems are bank dominated, and for the most part, not particularly complex. But net interest margins can be expected to decline across much of the region, a phenomenon generally associated with rising complexity as banks seek to raise profits through nontraditional activities and increased competition for deposits spurs faster financial innovation.

  • Asian financial systems are also likely to become more integrated with the rest of the world, and especially with each other.


For the next few decades, Asia’s economic growth is expected to lead the world—just as it has for the past generation. What does this mean for the future of the region’s financial sector? How will a region with highly diverse financial systems evolve? What can we say about the future of finance in Asia based on the experience of other countries?

As discussed in Chapter 2, Asia’s financial systems today are relatively large, but not particularly complex or integrated with the rest of the world. This chapter discusses what might cause those factors to change and how Asia’s financial systems are likely to look in the years ahead.


Asia’s already large financial systems can be expected to grow even larger. Over time, financial market development and economic growth both influence and support each other. A well-functioning financial sector plays a vital role in facilitating and sustaining economic growth (see, for instance, the literature survey by Zhuang and others [2009]). The financial sector plays this role in various ways, for example, by facilitating investment to raise potential growth, by providing incentives to save, or by reducing transaction costs (Bencivenga and Smith 1991; De Gregorio and Guidotti 1995; and Aziz and Duenwald 2002). An efficient financial system can also improve the efficiency and quality of investment (for instance, Greenwood and Jovanovich 1990; Ansari 2002). But causality can also run the other way: as Asian consumers grow wealthier and as companies grow larger and more sophisticated, demand for financial services such as mortgages, credit cards, and instruments to hedge duration, interest rate, and foreign exchange risks will also rise. In all likelihood, both forces are at play in Asia.

A cross-country panel data model (Box 6.1) sheds light on the relationship among macroeconomic factors, demographics, and legal and institutional developments and the growth of the financial sector. The main results are summarized in Table 6.1 and discussed in this chapter.

Table 6.1Determinants of the Growth of Financial Sector Size
Dependent Variable: Growth of Financial Sector Size (Percent of GDP)

Sample Countries over 2003–11
Lag of financial sector size−0.3***−0.4**−0.4**
Log GDP (based on purchasing power parity per capita)−46.1*−52.0*−97.2**
Capital account openness (Lane and Milesi-Ferretti measure)0.3*
Capital account openness (Chinn-Ito index)−19.7
Capital account openness (Quinn index)1.0
Interaction (Inflation × Capital account openness)−0.0*−0.6**−0.0**
Dependency ratio−3.8***−5.3***−5.9***
Trade openness (Total trade/GDP)0.40.4*0.4*
Bureaucratic quality (BQ)37.2***3.15.3
Law and order−7.05.4***−6.6
Interaction (Capital account openness × BQ)−0.1**13.4**−0.2
Cross-section fixed effectsYesYesYes
Time fixed effectsYesYesYes
Number of cross-section units383634
Total panel observations326308286
Adjusted R20.70.70.7
Sources: Chinn and Ito (2006); Lane and Milesi-Ferretti (2006, 2007); Quinn (1997); IMF, World Economic Outlook database; UN, World Population Prospects database; and IMF staff estimates.Note: Sample countries include Australia, Austria, Belgium, Brazil, Canada, China, Chile, Colombia, the Czech Republic, Denmark, Finland, France, Germany, Hungary, India, Indonesia, Ireland, Israel, Italy, Japan, Korea, Malaysia, Mexico, the Netherlands, Norway, the Philippines, Poland, Portugal, Russia, Singapore, South Africa, Spain, Sweden, Switzerland, Thailand, Turkey, the United Kingdom, and the United States. Heteroscedasticity robust standard errors are provided in the parentheses.*p < .1; **p < .05; ***p < .01.

Box 6.1.A Model of Financial Size

The size of the financial sector (as a percentage of GDP) is defined as total banking sector assets plus stock market capitalization plus the outstanding stock of domestic private and public debt securities. Following Chinn and Ito (2006) and Ayadi and others (2013), the econometric model is specified as

in which FS is the size of the financial sector (as a percentage of GDP), and X is a vector of control variables.1 To avoid the endogeneity problem and remove the impact of short-term cyclicality, the model is specified as growth-over-level regressions with nonoverlapping periods.

In particular, the lagged size of the financial sector is included in each regression. Log GDP per capita is included to control for wealth effects. Inflation is incorporated as the annual growth rate of the GDP deflator.

Three different measures are used for capital account openness. The first measure is an indicator proposed by Lane and Milesi-Ferretti (2006, 2007), which consists of the aggregate of gross external assets and liabilities (as defined in the International Investment Position of the Balance of Payments) measured as a percentage of nominal GDP in U.S. dollars. Two other measures were also considered—the Chinn-Ito and Quinn indices. Following Chinn and Ito (2006) and Ayadi and others (2013), the analysis includes trade openness, measured by total trade as a percentage of GDP, and the growth of government debt (as a percentage of GDP) to capture the impact of trade flows and fiscal policy on financial development, respectively.

Data availability limited the sample period to 2003–11. The initial sample of countries included the S-292 plus other Asian countries with 2012 nominal GDP of $150 billion or more. However, two economies—Luxembourg and the regional hub of Hong Kong SAR—turned out to be outliers and were dropped from the sample.3 The final sample included 38 economies.

The data were drawn from a number of sources. For the size of financial sector, data for total banking sector assets,4 stock market capitalization, and outstanding domestic private and public debt securities were obtained from the IMF’s International Financial Statistics database; Bloomberg, L.P.; and the Bank for International Settlements’ Statistics database, respectively. Macroeconomic data including purchasing-power-parity GDP per capita, the GDP deflator, trade openness, and growth of government debt were obtained from the IMF’s World Economic Outlook database. The measures of capital account openness, namely, the Lane and Milesi-Ferretti measure, Chinn-Ito index, and Quinn index, were obtained from Lane and Milesi-Ferretti (2006, 2007), Chinn and Ito (2002), and Quinn (1997), respectively. Finally, the dependency ratios were drawn from the World Population Prospects database of the United Nations, and the measures of legal and institutional development were drawn from the International Country Risk Guide database published by the PRS Group.

Following Chinn and Ito (2006) and Ayadi and others (2013), equation 6.1 was estimated using fixed-effect panel regressions with cross-section and time fixed effects. Time fixed effects were also included to control for possible time-specific exogenous shocks.

1 The dependent variable of equation (6.1) is actually the growth of the financial sector size as a percentage of the current-period GDP, that is, FSi,t–(GDPi,t−1 / GDPi,t)FSi,t−1. Explanatory variables X include (the log of) GDP per capita in purchasing-power-parity dollars, a measure of capital account openness, inflation, an interaction term between capital account openness and inflation, trade openness, growth of government debt, the dependency ratio, measures of legal development, and interaction terms between capital account openness and legal development measures.2 S-29 includes Australia, Austria, Belgium, Brazil, Canada, China, Denmark, Finland, France, Germany, Hong Kong SAR, India, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Norway, Poland, Russia, Singapore, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States.3 The sizes of the financial sectors in Luxembourg and Hong Kong were both greater than 1,500 percent of GDP during the sample period, much higher than the other countries in the sample.4 Total banking sector assets are defined as claims on central banks, plus net claims on government, plus domestic private credit, plus foreign assets.


In general, poor countries tend to show more rapid income growth than do rich countries. Poor countries can adopt technologies and import capital goods from rich countries, allowing their incomes to converge to rich-country levels (Figure 6.1, panel 2). Because rich countries tend to have large financial systems relative to the size of their economies, and poor countries tend to have shallower financial systems, we would expect that as poor countries become richer, their financial systems would grow even faster. That is, they would experience financial deepening.

Figure 6.1Growth of Financial Sector Size and Income Convergence

Sources: Bank for International Settlements; Banking Statistics database; Bloomberg, L.P.; IMF, International Financial Statistics database; IMF, World Economic Outlook database; and IMF staff calculations.

Note: Sample countries include Australia, Austria, Belgium, Brazil, Canada, China, Chile, Colombia, Czech Republic, Denmark, Finland, France, Germany, Hungary, India, Indonesia, Ireland, Israel, Italy, Japan, Korea, Malaysia, Mexico, Netherlands, Norway, the Philippines, Poland, Portugal, Russia, Singapore, South Africa, Spain, Sweden, Switzerland, Thailand, Turkey, the United Kingdom, and the United States. PPP = purchasing power parity.

The results of the empirical model provide support for convergence. Lagged purchasing-power-parity GDP per capita has a significantly negative impact on financial sector growth, implying that the richer a country is, the more slowly its financial system tends to grow (Figure 6.1). Similarly, countries with relatively large financial sectors tend to show slower growth in their financial sectors even when controlling for income per capita. That is, financial systems tend to grow faster in lower-income countries, but even when controlling for this effect, relatively small financial systems tend to converge toward larger ones. Thus, financial systems in Asia’s lower-middle-income economies, such as the Philippines and India, can be expected to grow more rapidly in the medium term than can the region’s richer countries, especially the advanced economies.

Capital Account Openness

As shown by Chinn and Ito (2006), capital account openness can be beneficial for financial sector growth when a country is equipped with well-developed legal systems and institutions. Capital account openness thus intuitively seems to be a factor that might affect financial sector development. Three measures of capital account openness, namely, the international investment position (IIP), Chinn-Ito index, and Quinn index, are included in the baseline regressions in Table 6.1. These three measures reflect different ways of thinking about capital account openness. The Quinn and Chinn-Ito measures, though compiled from different data, focus on the legal framework for capital account transactions (de jure openness), whereas the IIP looks at the total stock of foreign assets and liabilities held by nonresidents, and is thus a data-based de facto proxy for capital account openness. The results of the regressions are shown in columns I–III of Table 6.1, using each measure successively.

When measured by the IIP, capital account openness has a significantly positive impact on the growth of the financial sector. Comparisons are not straightforward, but in general, Asian economies tend to have relatively low IIPs.1 This is particularly true among Asia’s emerging economies, which are relatively closed. However, both China and India, along with other countries, have increasingly opened their capital accounts.2 As companies in the region globalize, domestic savers are able to invest more freely abroad, and as Asian companies grow more sophisticated and global, larger capital flows (Chapter 10) and greater integration with the rest of the world should occur.3 Given the large infrastructure needs of Asia’s emerging market economies, the need for more open capital accounts is expected to grow, which is likely to accelerate financial sector growth. Furthermore, a higher degree of trade openness is also likely to increase the growth of the financial sector, as suggested by the regression results.


Many observers (for example, Boyd, Levine, and Smith 2001) have noted that high inflation can discourage financial intermediation and adversely influence the development and growth of the banking sector and equity markets. Table 6.1 shows that higher inflation is associated with slower financial sector growth once capital account openness is controlled for. Intuitively, countries with higher inflation and more open capital accounts are likely to experience more capital flight, slowing financial development. In countries such as India and Indonesia, where inflation is relatively high and where capital accounts are being liberalized, bringing down inflation could help bolster stronger financial deepening in the future.


Another key change that will affect Asia in the medium and long term is demographics. Demographic trends vary widely across Asia. The region includes some of the world’s most quickly aging countries, such as Japan and Korea, and others on the cusp of enjoying a “demographic dividend,” where the working-age population is rising as a share of the total population, stimulating growth of the labor force and, all else equal, of the economy.

Dependency ratios affect saving rates, which in Asia is likely to be a significant issue (Heller 2006). Household survey studies, such as those by Chamon and Prasad (2008) and Chamon, Liu, and Prasad (2010), have also shown that higher dependency ratios are associated with lower saving. Lower saving, in turn, should imply slower financial deepening, as is confirmed in the regression analysis in Table 6.1.4

Thus, the rapid aging expected in many Asian countries, including China, the largest economy in the region, will likely act as a drag on financial deepening. However, in countries where dependency ratios are expected to decline, such as India and Indonesia, the rising number of working-age people saving for retirement could act as a spur to financial deepening.

Institutional Development

The relationship between financial sector growth and legal and institutional development has been widely studied. Work by La Porta and others (1997) shows that financial sector development is stronger within more developed institutional frameworks that protect and are better able to match the needs of investors. Chinn and Ito (2006) find that a higher level of financial openness spurs equity market development only if development of the legal system attains a specific threshold. Other studies have built upon these conclusions by showing that strong legal institutions, good democratic governance, and adequate implementation of financial reforms can have a significantly positive impact on financial development only when they are collectively present.

The specification in Table 6.1 follows Chinn and Ito (2006), including three indicators of legal and institutional development: the level of corruption, the quality of the bureaucratic system, and law and order. The interaction terms between each of these three indices and capital account openness are also included to control for the potential complementarities discussed in the literature.

Depending on which measure of capital account openness is used, the quality of the bureaucracy and law and order appear to have substantial and positive impacts on the growth of the financial sector. These results are consistent with other studies.

Institutional development has a particularly significant relationship with development of equity markets. Regardless of the stage of development of the rest of the financial sector, countries with higher law and order ratings tend to have more rapid growth in equity market capitalization. This relationship is reinforced by capital account openness; presumably countries with better governance and more open capital accounts see even stronger growth in equity markets because foreign investors more willingly enter the market.

Other Factors

Finally, some variables that might be expected to be related to financial sector growth do not appear to support deepening once the other variables in the specification are taken into account. Chinn and Ito (2006) and others suggest that liberalization in goods markets is a precondition for liberalization of financial markets. Because trade openness is an area in which emerging markets in general—and Asia in particular—do quite well by international comparison, it might be expected to be a significant factor, but regression results do not strongly support this hypothesis. Why this is the case is not clear, though one reason could be Asia’s tightly regulated financial sector in many countries, which has impeded the impact of Asia’s relatively liberal environment for goods trade.

Similarly, the growth of government debt does not appear to be tied to the overall growth of the financial sector (Table 6.1). Fiscal pressures that lead to a rapid increase in government debt might have negative effects on financial markets because rapid growth in debt might crowd out private investment or raise the level of inflation. Countries with larger stocks of public debt tend to have less efficient financial sectors than do countries with lower levels of public debt (Ayadi and others 2013). These hypotheses are consistent with the Indian experience. In other cases, prudent fiscal policies over time have meant that government debt markets are relatively small, making it more difficult to diversify domestic capital markets and establish benchmark interest rates.

Complexity and Domestic Interconnectedness

The complexity of Asia’s financial systems mirrors their size. The financial centers of Hong Kong SAR and Singapore, along with advanced economies such as Australia, Japan, Korea, and New Zealand, have financial systems as complex as any in Europe or North America. However, emerging market financial systems tend to be less complex, and this holds true in Asia (Chapter 2).

Bank lending tends to dominate financial sectors in emerging Asia, and the largest share of this bank lending is at relatively short maturities. Equity markets are large, but, as discussed in Chapter 4, they tend to be highly volatile. However, despite the rapid growth of corporate bond markets in recent years, long-term debt options tend to be more limited. In many countries, bond markets, even for public debt, tend to be relatively illiquid, and the lion’s shares of issuers tend to be highly rated companies, especially publicly traded companies. In addition to these supply problems, demand is also an issue. Emerging Asia tends to have fewer local long-term buy-and-hold investors than do advanced economies, because it has relatively small pension funds and insurance companies. In addition, in many countries in emerging Asia, pension funds and insurance companies are publicly owned, with regulations that complicate their participation in private sector debt markets, especially at higher risk ratings. Many Asian emerging markets also lack the infrastructure of financial data, credit expertise, and incentives needed to catalyze lending to small firms or innovative start-ups (Sheng, Ng, and Edelmann 2013).

Whether this pattern will change in Asian emerging markets will depend on, among other things, the relative returns from bank lending versus other kinds of investment. During the past decade, net interest margins in Asia have been rising albeit slowly (Figure 6.2, panel 1), which has limited the incentives for banks to diversify their asset portfolios and seek higher returns from nontraditional banking activities. This growth focus on traditional lending is also visible in banks’ sources of income; the share of banks’ total income contributed by trading and other nontraditional activities has declined in recent years (Figure 6.2, panel 2).

Figure 6.2Net Interest Margin and Composition of Bank Assets


Source: World Bank, Global Financial Development database.

Note: Central and Eastern Europe includes Bosnia and Herzegovina, Croatia, FYR Macedonia, Romania, and Turkey. Latin America and the Caribbean includes Brazil, Chile, Colombia, Costa Rica, Mexico, and Paraguay. Advanced economies include Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Portugal, Spain, and the United States. Asia includes Australia, China, Hong Kong SAR, India, Indonesia, Japan, Malaysia, the Philippines, Republic of Korea, Singapore, Sri Lanka, and Thailand.

1 Does not include Australia, Hong Kong SAR, the Philippines, Singapore, or Sri Lanka, as data were not available.

However, these conditions are likely to change in the medium term. As the global economy recovers and advanced economies unwind their highly accommodative monetary policies, interest rates are likely to rise. The higher global cost of capital will put pressure on net interest margins, improving the relative tradeoff of moving into unconventional and more complex activities.

Foreign investors are another potential source for such diversification. But foreign participation tends to be greatest in open and liquid markets. Asian markets often are not as open to foreigners as are markets in other emerging regions (Chapter 2), and poor liquidity and other factors tend to discourage foreign participation (Chapters 4 and 5).

Domestic factors will matter as well. In many Asian countries, net interest rate margins are likely to come under modest downward pressure due to competition among lenders for business and for deposits. In countries such as Malaysia and Indonesia, where most loans are at floating rates, competition for higher-quality borrowers could be particularly strong. The continued deepening of equity markets and development of local currency bond markets also will offer increasingly varied options for the large and high-quality borrowers who form the most stable segment of bank lending in most countries today. As banks compete for this business, lending margins are likely to fall. The liability side of balance sheets also will matter. In markets in which retail deposits form the backbone of bank financing, as in Asia’s emerging markets, competition for deposits will erode net interest margins from below, pushing banks to become more innovative in measuring risk, pursuing new lines of business activity, and developing new products for savers.

Regulatory changes also may have an impact. For example, meeting the Basel III liquidity coverage ratio requirement is expected to lead to intensified competition for stable retail deposits. This competition will likely put greater pressure on interest margins in countries such as Australia—even taking into account that Australia, with a system dominated by four major banks, has a relatively concentrated, and thus in theory less competitive, banking sector. In China, rates on bank deposits have generally been lower than returns on alternative products, such as wealth management products purchased by retail investors, and on other items, often offered by banks, that are purchased by larger corporate borrowers. As deposit rates are liberalized, bank deposit rates can be expected to converge with rates on these alternative products, potentially putting pressure on margins. The regional hubs of Hong Kong SAR and Singapore may prove to be important exceptions to the regional trend of declining net interest margins. This is due to both economies’ global reach and opportunities to expand their lending activities in profitable emerging markets.

Across the region, this potential squeezing, or at least stabilization, of net interest margins will be a strong incentive for Asian banks to move away from traditional banking toward more complex and riskier business activities and financial instruments. Indeed, there is a strong and negative relationship between net interest margin and the importance of non-interest-earning assets as a share of total assets (Figure 6.3, panel 1). Cross-country annual data from 42 countries covering the period 2000–11 show this correlation; moreover, the correlation between net interest margin and other earning assets to total assets, and between net interest margin and other interest-bearing liabilities to total liabilities, are statistically significant (Table 6.2).

Figure 6.3Banks’ Lending Profitability and Nontraditional Income

Sources: Bankscope; World Bank, Global Financial Development database; IMF, International Financial Statistics database; and IMF staff calculations.

Note: Central and Eastern Europe (CEE) comprises Bosnia and Herzegovina, Bulgaria, Croatia, Hungary, Latvia, Lithuania, FYR Macedonia, Poland, Romania, and Turkey. Latin America and the Caribbean (LAC) comprises Brazil, Chile, Colombia, Costa Rica, El Salvador, Mexico, and Paraguay. Advanced economies comprise Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, the Slovak Republic, Slovenia, Spain, and the United States. Middle East and North Africa (MENA) comprises Algeria and Pakistan. Sub-Saharan Africa (SSA) comprises Kenya, Mauritius, South Africa, and Uganda. Asia comprises Indonesia, Japan, Malaysia, the Philippines, and Thailand.

Table 6.2Correlation with Net Interest Margins
VariableCorrelation Coefficient
Other earning assets to total assets−0.3
Other interest-bearing liabilities to total liabilities−0.5
Sample Period: 2000–11
Number of Observations: 210
Sources: Bankscope; World Bank, Global Financial Development database; and IMF staff calculations.Note: *, **, and *** denote that the correlation coefficients are statistically different from zero at the 10 percent, 5 percent, and 1 percent significance levels, respectively.

However, a key result of this process is likely to be a push by banks into higher-risk loan segments, raising the stakes for regulators, an issue discussed in Chapter 11. As banks’ reliance on non-interest income increases (that is, as their business models become more complex), so does their reliance on wholesale funding. The importance of interbank markets also increases. (Figure 6.3, panels 2–4). More competition for deposits also may spur more rapid growth in nonbank financial institutions and shadow banking, which could complicate the task for regulators who will have to supervise a more diffuse financial system.

The same factors that will drive Asian financial systems toward greater complexity also will likely lead to systems with greater domestic interconnectedness. As banks move toward more nontraditional activities, they are likely to look for cheaper alternative sources of market funding—wholesale or interbank—to finance these activities. Indeed, cross-country data show a positive and statistically significant correlation between the ratio of non-interest income to total income on the one hand, and the ratios of wholesale funding to total liabilities and of interbank assets (or liabilities) to total assets (or liabilities) on the other (Table 6.3). Some of this market funding is likely to come from other financial institutions. Thus, as financial systems in Asia become more complex, domestic financial institutions are likely to become increasingly interconnected. Furthermore, in the longer term, Basel III liquidity requirements, and in particular the need to meet the net stable funding ratio requirement, may encourage borrowers to look more to institutional investors, such as pension funds and insurance companies, to fund their longer-maturity projects.

Table 6.3Correlation with Non-Interest Income to Total Income
VariableCorrelation Coefficient
Ratio of wholesale funding to total liabilities0.4
Ratio of interbank assets to total assets0.3
Ratio of interbank liabilities to total liabilities0.1
Sample period: 2000–11
Number of observations: 210
Sources: IMF, International Financial Statistics database; World Bank, Global Financial Development database; and IMF staff calculations.Note: *, **, and *** denote that the correlation coefficients are statistically different from zero at the 10 percent, 5 percent, and 1 percent significance levels, respectively.

International Interconnectedness

As shown in Chapter 2, Asian financial systems are less connected to the rest of the world than are financial systems in other regions. As Asian financial systems grow larger and more complex, international interconnectedness will also rise. In fact, various studies suggest that many of the same factors that drive financial sector deepening are also associated with greater international connectedness. Chief among these factors is income. Aizenman and Noy (2009) find that a $1,000 increase in GDP per capita is associated with an increase in the IIP of 0.1–0.3 percentage point of GDP. Larger financial systems also tend to be more globally interconnected.5

Countries with more openness toward goods trade also tend to become more financially interconnected. Aizenman and Noy (2009) find that a one standard deviation increase in the trade openness index is associated with a 9.5 percent increase in de facto financial openness. One reason this occurs is that greater trade openness by necessity deepens financial connections with the rest of the world. These interconnections increase the cost of enforcing financial repression, thereby reducing the effectiveness of financial repression as an implicit tax on capital flows and increasing the de facto financial openness. In the future, as GDP per capita and trade openness are expected to continue rising in Asia, particularly in emerging Asia, economies such as China and India are likely to have higher degrees of financial openness given that they are already finding it difficult to maintain financial repression.

Stock market liberalizations, privatization of state-owned companies, and other steps toward financial liberalization are also associated with greater international interconnectedness. During the 1990s, the privatization of state-owned enterprises in central and eastern Europe and other regions led to a large jump in capital inflows. In East Asia, foreign investors’ purchases of local banks in financial distress tripled the share of foreign-controlled banking assets from 2 percent in 1994 to 6 percent in 1999. Countries with larger stock market capitalization also tend to have more international interconnectedness, likely due to the greater attractiveness to foreign investors of more liquid and diversified equity markets in recipient countries. The presence of institutional investors also is closely linked to international interconnectedness.6 Here, too, financial liberalization and capital account liberalization reinforce each other by reducing the effectiveness of financial repression, leading to less market distortion and better capital allocations.

In addition, the demographic shifts, especially changes in dependency ratios, that affect saving rates in both advanced and emerging markets are associated with greater global interconnectedness. In Asia, where dependency ratios, on average, are lower than they are in other regions or in advanced markets, rising dependency ratios are thus likely to spur higher saving rates. Investing this larger savings pool domestically will likely drive down the rate of return on capital, particularly relative to that in the emerging markets with low capital levels. As a result, capital will tend to flow to countries where it can earn higher returns.

These capital inflows can be expected to particularly benefit Asia’s rapidly growing economies with young populations, such as Indonesia and India. Faster growth in these economies should create more potential opportunities for investors than there will be in the region’s slower-growing advanced and emerging market economies. Integration of the region’s faster-growing economies will also accelerate because of gravity effects. In general, cross-border investments tend to flow from countries to their own neighbors, where information and some transaction costs tend to be lower. Thus, as Asia’s savings look for higher returns, they can be expected, on average, to concentrate more in the region itself than in the rest of the world, especially given the large infrastructure needs of the region’s rapidly growing economies with young populations.

What Does the Future Look Like?

How might Asia’s financial sectors evolve? As discussed elsewhere in this chapter, numerous factors will influence the size and structure of Asian financial markets in the future. Extrapolating the model laid out in Table 6.1 provides some insight into how these factors will affect Asia’s financial sectors and what the future might look like. First and foremost is the relationship with economic growth. As incomes in emerging Asia rise, the process of catch-up that has allowed them to grow rapidly in recent years can be expected to continue. However, higher incomes will lead to slower growth rates, so the pace of convergence should decline. The degree to which growth will cause most Asian emerging markets to narrow the gaps with developed economies will vary. For example, by 2030, growth alone could raise the size of Vietnam’s banking sector by about 13.5 percentage points of GDP. But growth should have a smaller effect on Asia’s richer economies. For example, Japan should see only a marginal further deepening of its financial sector resulting from economic growth, with banking sector assets rising only by about 3 to 4 percent of GDP by 2030. This is because Japan already has mature financial markets and its income growth per capita is expected to be relatively slow and from a high base.

Figure 6.4 puts these results into context. Panel 1 presents the projections for four selected countries: China, India, the United Kingdom, and the United States. Panel 2 shows the regional averages for emerging and advanced Asian and non-Asian economies. The effects, however, are relatively small for emerging markets. Considering the rapid growth in emerging market banking sectors in recent decades, this relatively unimpressive expectation of future growth is somewhat surprising. One reason for the low average forecast is the historical frequency of financial crises. The emerging market crises of the 1990s slowed or reversed the growth of emerging market banking sectors, pulling down the historical average growth rate, and affecting these forecasts. Because the quality of regulation and supervision has improved, and macroeconomic fundamentals are broadly better in Asia’s emerging market economies today than they were in the 1990s, we should expect to see fewer homegrown crises in the future.

Figure 6.4Effect of Income Growth on Financial Sector Size

(Financial sector size as a percentage of GDP)

Source: IMF staff calculations.

In addition, other macroeconomic and social factors are likely to have a significant impact. Chief among these are rising dependency ratios. Financial sector growth will be further weighed down by the rising share of retirees in the population and the accompanying drawdown of their savings. According to projections from the UN’s World Population Prospects database (the 2012 Revision) and the IMF’s World Economic Outlook database (the April 2014 Update), the dependency ratios in most Asian countries are expected to rise during 2012–20 (Figure 6.5),7 and purchasing power parity GDP per capita will rise in all countries. These negative effects will be significant in many countries, especially in Japan and Korea. But Vietnam will also see large increases in the share of the population older than the working age.

Figure 6.5Asia Demographic Change

(Percent of total population, 2000–30)

Sources: United Nations; and IMF staff calculations.

China is an unusual case for both macroeconomic and social reasons. Banking assets as a share of GDP are already higher than they are in the United States. They are comparable to those in Germany. This partly reflects a postcrisis credit boom that can be expected to unwind gradually during the next few years. In the future, income per capita is still expected to grow at a fast rate, which can be expected to boost the size of the financial sector, whereas the rapid pace of aging can be expected to weigh it down. With the relative importance of these factors unclear, the overall direction of China’s financial sector is uncertain. Nonetheless, it will certainly remain the largest financial sector in Asia.

Capital account openness will be another key factor in determining the future financial landscape of Asia. Capital account openness, at least as measured by the de facto IIP measure discussed elsewhere in this chapter, is linked with GDP per capita (Figure 6.6). Within Asia, countries at broadly similar levels of income differ widely in their openness by IIP, and thus the extent to which further opening is likely to occur is difficult to project. But using Australia, a relatively open advanced economy, as a model, calculations based on the regression results in Table 6.1 show the effect of further liberalization on the size of Asian financial sectors. If relatively open Asian economies, such as Malaysia, were to become as open by 2020 as Australia is today, the size of the financial sector would increase by an average of 13 percentage points of GDP. For less open countries, the effect is even larger. Indonesia’s current IIP, for example, is 80 percent of GDP compared with Malaysia’s 230 percent. If Indonesia were to rise to Australia’s level (unlikely in such a short time frame), the size of the financial sector would increase by about 46 percentage points of GDP. For economies that are even more closed than Indonesia’s, such as India’s, the effect would be even larger. Although, again, such a rapid increase in IIP is unlikely in such a short period.

Figure 6.6Capital Account Openness and Purchasing Power Parity (PPP) GDP per Capita

(2003–11 average)

Sources: Lane and Milesi-Ferretti (2006, 2007); and IMF, World Economic Outlook database.

Note: Sample countries include Australia, Austria, Belgium, Brazil, Canada, China, Chile, Colombia, the Czech Republic, Denmark, Finland, France, Germany, Hungary, India, Indonesia, Ireland, Israel, Italy, Japan, Korea, Malaysia, Mexico, the Netherlands, Norway, the Philippines, Poland, Portugal, Russia, Singapore, South Africa, Spain, Sweden, Switzerland, Thailand, Turkey, the United Kingdom, and the United States. IIP = international investment position.

China is, again, an unusual case. China’s capital account is relatively open in de facto terms, at about 109 percent of GDP in 2011, but this is partly due to its very large stock of central bank international reserves. Excluding these reserves tells a somewhat different story. China is on the low end of openness compared with other Asian emerging markets.8 A lifting of China’s restrictions on both inward and outward investment can be expected to lead not only to an increase in inflows as foreign investors gain greater access to Chinese assets, but also to potentially substantial outflows, as Chinese savings kept currently within the country would be able to be invested abroad. These outflows could be substantial (Bayoumi and Ohnsorge 2013). China’s capital account openness would thus provide domestic financial firms with more opportunities to diversify and expand their foreign portfolios while also allowing domestic savers to invest in a wider range of assets.

Other variables are more difficult to forecast. Governance indicators, like capital account openness, are highly correlated with income. As the incomes of Asian countries rise, it can be expected that bureaucratic quality and law-and-order indicators also will improve, further spurring the development of Asian financial markets. Indeed, these improvements should help strengthen the deepening of equity markets—one of Asia’s key deficiencies, as improving governance, higher incomes, and continued capital account liberalization reinforce one another.

As discussed, this large growth in the size of Asian financial sectors will be accompanied by a rise in complexity and interconnectedness. The eventual normalization of global interest rates, the impact of global regulatory reforms (see Chapter 11), declining interest margins, and other factors should spur more innovation among financial institutions, including nonbank entities, and lead to increasing complexity within Asia’s financial systems. This process is likely to go farthest in markets in which net interest margins have already been falling, such as Malaysia and Korea. In countries where there is less competition, deposit growth is more robust, but in countries where financial repression is more effective because of closed capital accounts, this process is likely to go more slowly.

Finally, Asia’s large and increasingly complex financial systems can be expected to further integrate with the rest of the world. While these linkages are currently smaller than they are in many other regions, diversification of Asia’s large savings pools, further liberalization of domestic equity and bond markets, and especially Asia’s rising income levels, should lead Asian countries’ financial linkages to each other and to the rest of the world. With these linkages, Asia’s financial systems will more closely resemble the region’s deep internal and external trade relationships. And as with trade, this integration should be expected to increase intraregional linkages.


Asia’s financial sector growth can be influenced by many macroeconomic and social factors, particularly income and demographics. The rising income in this region has been accompanied by rapid financial sector growth since 2002. The size of financial sectors in the region’s lower-middle-income countries can be expected to converge in the medium term to the size of those in the richer economies, especially the advanced economies. Another key factor that will affect Asia’s financial sector in the medium and long terms is demographics. Higher dependency ratios in many Asian countries, especially the advanced economies, tend to be associated with less savings, and in turn, imply slower financial deepening. Other factors that might affect Asia’s financial sector growth, such as inflation, capital account openness, and legal and institutional development, are likely to be linked with income.

Asia’s financial sectors are mostly bank dominated. The financial centers of Hong Kong SAR and Singapore, along with the advanced economies in the region, have financial systems as complex as any in Europe and North America. However, the financial sectors in the region’s emerging markets tend to be less complex and dominated by banks. Because net interest margins can be expected to decline across the region, Asian banks will have strong incentives to move away from traditional banking toward more complex business activities and financial instruments, leading to more complex and interconnected financial sectors in the region.

In the future, Asia’s financial sectors can be expected to be more integrated with the rest of the world and especially with each other, as banks search for profits through more complex business activities and financial instruments. In addition, this process could be accelerated as Asia’s large savings pools become more diversified, domestic equity and bond markets become more liberalized, and most important, income levels rise further.


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In 2011, Japan and Korea both had IIPs below 200 percent of GDP, compared with 318 percent of GDP in the United States and 527 percent of GDP among all non-Asian advanced economies. Hong Kong SAR and Singapore, however, had IIPs of 2,212 and 1,576 percent of GDP, respectively—higher than any non-Asian advanced economy.

Under the Lane and Milesi-Ferretti measure, China shows up as relatively open, but once the large international reserves at the People’s Bank of China are taken into account, the ratio is lower.

Both Chinese and Indian corporations have already become large buyers of foreign companies, with Chinese outward foreign direct investment reaching $73 billion in 2013, and Indian foreign direct investment reaching $18 billion.

The main specification in the regression analysis includes the total dependency ratio as measured by the number of people under age 15 and those over age 64, divided by the number of people between ages 15 and 64.

However, this may partly be due to the statistical artifact that larger IIPs by necessity mean larger financial systems because foreign assets and liabilities will be held or issued by financial institutions.

With institutional investors, however, endogeneity concerns are particularly pronounced because these investors focus on the kind of liquid, transparent markets that already tend to be well developed and reasonably open.

Except India, Indonesia, Malaysia, and the Philippines, where dependency ratios are projected to decline slightly over this period.

In China, IIP assets and liabilities, less official reserves, were about 64 percent of GDP at end-2013. In Indonesia, the total was 75 percent, while in Malaysia and Thailand it exceeded 120 percent.

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